Active Investing in Japan

Internet Initiative Japan (IIJI) (3774) is a Japanese internet service provider offering a full suite of connectivity and outsourcing services. It is a pioneer among Japanese internet-related companies, having originally listed its shares on the Nasdaq in 1999, before eventually listing in Tokyo (Mothers) in 2005 and later transitioning to Topix 1st Section.

At the end of February, I submitted a letter to the company’s chairman (Mr. Suzuki) and its other directors. While applauding them for their prior decision to repurchase shares, the timing of which coincided with the bottoming of IIJ’s stock, and also for maintaining the dividend, I voiced some concerns and submitted proposals that are either to be actioned or designated for resolution at the Annual Shareholders’ Meeting this June. IIJ’s Investor Relations Officer has been helpful and cordial, and has already forwarded my letter and proposals. Below, I will briefly outline my position.

Unfortunately, despite having listed in the U.S., making it to Topix-1, and having a reasonable level of awareness within commerce and government in Japan, IIJ remains a largely unknown company in the investment community. Since I’ve been a shareholder for a while now I am not pleased about this, but it in fact represents an opportunity.

A cursory review of IIJ’s financials will show that the company met some hard times in 2008 (fiscal year-end March ‘09), as did most companies, but it remained profitable. However, given the weak economy in Japan and lingering deflation, 2009 (FYE 3/2010) is not looking as if it will be significantly better than 2008; that is, as revenues are forecast to be lower, although earnings are expected to rise about 20%, but still be only about a third of what they were between fiscal years 2006-2008. Meantime, IIJ is moving right along with capex, granted some of it is regarded as critical given the upgrade cycle of networking equipment. I have asked IIJ to review its capex/depreciation, while considering the models of Google and Amazon for cloud computing, an area, along with mobile connectivity, that represents great opportunity for the company.

One of my chief concerns relates to the level of capex and correspondingly, the heavy depreciation. Furthermore, the growth in assets, while it had led to top-line growth, it hasn’t brought an increase this year, and has not generated growth on the bottom-line for the past two years. To make matters worse, IIJ is sitting on a sizable pile of cash, nearly ¥8.5 billion ($94M) as of the most recent quarter’s end, compared to total assets of around ¥47 billion, and a market capitalization of around ¥40 billion (keep in mind that its shares are up about 25% in the past month). The company doesn’t have long-term debt, but it does utilize capital leases, which represent a “long-term” liability of ¥3.9 billion. IIJ has no working capital concerns whatsoever, and has access to very cheap bank lending facilities at a cost of capital under 2%.

My specific proposals involve:

I. A stock-split of the ordinary shares of at least 10:1, but preferably 100:1. Correspondingly, in light of the 400:1 ADR-to-Ordinary ratio and IIJ’s subsequent five-dollar per share ADSs, again I suggest a 100:1 ordinary split and a 1:4 ADR split. While stock splits don’t impact the fundamentals, they would most certainly help improve IIJ’s trading liquidity and improve its potential investor base.

II. Switch to a quarterly dividend payout schedule instead of biannually. I suggest this given it is common practice in the U.S. and the appreciation most shareholders will have for a more frequent payout.

II. Announce another stock buyback. I have already summarized IIJ’s cash position above. I regard IIJ as undervalued both based on a valuation of its assets and a return to at least the levels of profitability it achieved in the recent past. Use of cash for share repurchases is ideal considering IIJ’s recent low ROA (and ROE) and its foray into a non-core business (see below).

III. Allow shareholders to vote on any investment or acquisition in excess of ¥1 billion that does not involve IIJ’s core business related to internet connectivity and services. This proposal is prompted by its new ATM business. It has a majority stake in a business that places ATM’s in pachinko parlors (similar to how ATMs are placed in casinos). While this business may someday become profitable (I have asked for revenues/earnings guidance), it has accumulated losses to-date of over ¥1 billion, and it will need even more capital before all the thousands of ATMs are deployed.

One-year stock chart of IIJI:

Disclosure: The author owns shares of IIJ. Note this article does not constitute investment advice.

The latest and largest equity dilution — approx. $5.6B; 30% s/o — by Nomura (JP: 8604) (NMR: 7.45 +2.90%) has sent its shares down 16% to ¥573 in Tokyo ($6.35 at ¥90.3/$1) following an earlier rout in NY.  I think the stock has further to fall, given that it was saved by its daily loss-limit (‘limit-down’) in Tokyo with volume of only 8.9 million shares. Volume thus far in September has ranged from a low of 17M shares traded to start the month, to a high of 65M last Friday.

At this point, the $5.6B it plans to raise over the next month would have been more than enough to have just acquired Lehman USA last year! Now the company and its shareholders face the challenge and risk of having to use the capital to expand existing U.S. operations and somehow grow some new business. Doing these things (profitably) has never been easy for Nomura, though it’s always been a dream of sorts.

Meantime, the stock is massively diluted, and unattractive at current levels due to the uncertainty of how effectively it will deploy the capital — it’s about 40% above its March low. While I agree with Goldman’s take that the capital raising is offensive, rather than defensive, in nature, I think it’s a little much. The Japanese business press does too, apparently, dubbing Nomura and the broader market’s sell-off the “Nomura shock.”

- No position in any companies mentioned.

The author’s intent is not to be misleading, but rather to be as frank as possible, regarding the longstanding debate of whether or not Japanese stocks are truly undervalued. In short, the answer is  no. I no longer believe Japanese stocks are undervalued, not to the extent that I once did, and not to the lengths that some pundits and money managers try to make a case for. In fact, I would argue that Japanese stocks may best be described as being closer to fair value instead of being deeply undervalued. I mean Japanese stocks, for the foreseeable future, may be destined to be “undervalued” by traditional metrics, but fairly valued by the market and in relation to the economy. continue reading…

See the clip below (re. cross shareholding) from an article discussing Japanese stocks at a 26-year low (as of Monday’s close) in yesterday’s Wall Street Journal. Earlier this week I discussed cross shareholdings in Poisonous cross shareholdings may be helpful in reaching a quicker bottom.

clipped from online.wsj.com Japan’s banks, in particular, had seemed to be in good shape. Remaining cautious after their bad-loan problem, they largely avoided exposure to U.S. subprime mortgages. But the falling shares highlight one area of weakness. Japan’s banks are allowed to invest some of their capital base — the pool of funds against which they lend money — in stocks. The practice is a legacy of the traditional practice of “cross shareholding,” where banks and their borrowers held stakes in each other to cement ties. Such holdings by Japan’s banks now represent about 3% of the value of the Japanese stock market. Mitsubishi UFJ held a portfolio of Japanese stocks valued at 6.1 trillion yen, with unrealized gains of 1.8 trillion yen, as of June. With Japan’s stock market falling 40% since then, the portfolio is estimated to have shrunk to less than 3.7 trillion yen, representing a valuation loss of 630 billion yen, according to an estimate by Kristine Li, a banking analyst for KBC Securities in Tokyo.

Media reports and eventual confirmation (by Mitsubishi UFJ) of contemplation of raising capital among Japan’s mega banks warrants far more discussion. As stated earlier, the reasoning of MUFJ (JP: 8306) (MTU: 5.21 +1.17%) is understandable (growth at almost any cost), but unacceptable for existing shareholders. For Mizuho (JP: 8411) (MFG: 4.25 +1.43%) and Mitsui Sumitomo (JP: 8316), however, it raises some very important questions with implications for the entire market.

What I’m most interested in here, is how bad the broad market sell-off — stocks are now down nearly 50% since the start of the new fiscal year — is impacting balance sheets, which will see (more) writedowns of shareholders’ equity. As the painful reality of global deleveraging sets further in, equities continue to be “re-priced.” We knew earnings estimates had to come down. What we didn’t know was that forex would be so damaging. Is the next step to learn that the steep and broad market fall has induced a further shaving of shareholder equity? This is a vicious spiral and almost Bermuda Triangle-like. More corporate failures are inevitable. Likewise for even deeper discounted valuations. That said, the bright side to all of this is that there certainly is a floor and it is held up strongly by the cross shareholdings. Yes, the selling will have to end for obvious reasons. And companies can help themselves by acquiring subsidiaries and maybe even competitors. Talk about timing for a golden era of inward M&A! So, given the precipitous fall, it is a no-brainer that we’re closer to the bottom. However, as I’ve been saying repeatedly, patient capital is a must. Anybody have capital and want to talk?

Japanese stocks “rallied” a spectacular 14% last Tuesday, but in spite of that (and being surrounded by massive days of selling), I lacked the broader market’s bullish conviction and explained why in “Trying not to rain on the Tokyo stock parade.” Overnight, the Nikkei sold-off about 6.8% to fall back below 9,000 again to 8,674, erasing the gains from a three-day rally. During that period there was a spooky appearance of bullish stories on Japan, particularly advocating banks. In fact, it is a recurring theme: whenever there’s page space to be filled, a couple days of higher closes in Tokyo, or the desire to sound smart and talk about valuations. Unfortunately, it is easy to be misinformed and fooled. continue reading…

In a report issued today and covered by Reuters (see below for clip and link to Japanese original), Goldman Sachs says it sees a possible full recovery for Japanese stocks from mid-2009. On one hand, GS warns that a further slowdown in the global economy represents further downside risk for Japanese stocks given the nation’s high reliance on exports. On the other hand, corporate profits are seen recovering from late 2009 with fiscal year 2010 profits back to positive y-o-y growth. For FY March ‘09, GS now forecasts profits to fall 12.0%, compared to 10.2% previously. For FY ‘10, GS sees profits up 6.0%, but that’s less than the 12.5% it previously estimated.

GS is not alone in its earlier assessments of Japan, noting the nation’s comparatively better ability to cope with high oil prices; however, the fact remains that Japan still imports a significant volume of oil to support its energy producing needs. In addition, GS has previously cited the attractive valuation of Japanese stocks, with some 60% or so trading below book value and dividend yields of 1.9% exceeding the 10-year JGB of 1.5%. Although it’s true that Japanese stocks have outperformed in recent months, it’s also true that Japanese stocks are down around 25% across the board since a year ago. Stocks are down even more compared to recent years’ highs, which never touched 20,000, in the case of the N225.

So, while the perception of attractive value exists in Japan, the reality of realizing or unlocking this value remains elusive.

clipped from jp.reuters.com 日本株、本格的な上昇は09年中盤以降の可能性＝ＧＳ証券

Below are some additional thoughts on the latest MUFG-UB offer (these comments were originally posted in response to an article published by Reuters; edited for style/formatting).

UB’s (UB: 0.00 N/A) Special Committee is very opportunistic and knows what it is doing. It has effectively taken its minority stake hostage vis a vis its board representation and a long-standing one at that for the Chief of the Committee. At the end of the day, there is absolutely no “reputation risk” as MUFG (MTU: 5.21 +1.17%) fears. Why? Nobody on Wall Street cares!

So, is MUFG overpaying? Of course it is. Is it a good deal — yes, great for UBOC in this market. Will MUFG pay up even further as some Tokyo analysts suggest? Probably not. If so, it is even more concerning why there is such urgency on the part of MUFG. Meantime MUFG shareholders suffer and shareholder value is sacrificed over the desire to expand overseas (note it’s great to seek overseas expansion, but it has to be done at the right cost).

Bottom line, this is a so-called “safe” deal for a Japanese mega-bank. Union Bank’s SC knows this and is milking it. The offer in no way signals a bottom for banks’ woes. It also does not necessarily signal a forthcoming buying spree by foreign banks of their overseas subsidiaries. However, it would make sense for opportunistic HFs and other traders to buy shares and hold-out for more! See: MUFG Now Really Overpaying for Union Bank, Oh Well (Shikataganai).

$58 a share — no! $63 a share — no! $73 a share — oh, sure, might as well, especially in this market. Hats off to Mr. Farman and company for helping the little guys at Union Bank (UB: 0.00 N/A) get paid. Still scratching your head about what Mitsubishi UFJ (MTU: 5.21 +1.17%) is thinking? Keep scratching. For more background see both the FT clip below and last week’s “Mitsubishi UFJ Overpaying for UnionBanCal.” As stated then, this is a “safe” acquisition, but one that is even more dubious in terms of shareholder value. Shikataganai (MUFG shareholders just sigh and shrug their shoulders … accept the fact that this is the cost of doing (more) business in the U.S. even in today’s market climate).

FD: No position in any companies mentioned. Gladly with regards to MTU and unfortunately in the case of UB.

clipped from us.ft.com MUFG clinches US bank with higher offer The deal, which values UNBC at 2.3 times book value, is considered relatively expensive by analysts. However, MUFG has a track record managing UNBC and knows the San Francisco bank well, making the acquisition a relatively safe bet, according to one analyst. “The Special Committee of independent directors is very pleased to have negotiated a transaction with BTMU that we believe is highly attractive and in the best interests of the minority shareholders,” Richard Farman, chairman of the special committee, said.

This is not a bad deal, at all, for existing (non-MUFG) UnionBanCal (UB: 0.00 N/A) shareholders: a decent premium pushing the stock to a new 52wk high, amidst ongoing market woes, and not to mention UB’s last quote of $65+, which is above the $63 bid by Mitsubishi UFJ Financial Group (MTU: 5.21 +1.17%). Now, as for MUFG shareholders, you have to scratch your head and wonder if the remaining stake really could not have been acquired at a cheaper price — UB traded as low as $35 a month ago! Furthermore, MUFG seems to have implied it is willing to pay even higher to complete the deal, thus the >$63 trading.

If anything, this is a safe acquisition for MUFG, but not necessarily one to add much shareholder value, if any, at least over the next few years. What it does allow for, however, is further acquisitions. What’s next? How about neighbor Santa Clara-based SVB Financial Group (SIVB: 46.03 -0.84%)? With a $1.9B market cap, it is not insignificant, and it has equally as attractive margins. Unfortunately again for MUFG shareholders, SIVB is not far off 52wk and all-time levels and there would certainly have to be some premium beyond that considering the heavy institutional ownership.
*See the FT clip below. FD: No stakes in any companies mentioned. continue reading…